Sovereign Debt Is the Next Big Worry

By MICHAEL CASEY (WSJ)

NEW YORK -- If you're looking for one global risk to really worry about, look no further than the mountain of debt accumulated by governments in their efforts to support domestic economies.

Moody's Investors Service says there's $49.5 trillion of sovereign debt outstanding -- and this week, ratings firms, and some jumpy bond traders, have shone a glaring light on it.

The raters are worried that governments' massive deficit-spending campaigns to pull their economies out of last year's crisis won't produce enough economic growth to pay for itself.
But none of this is new. A month ago, the International Monetary Fund projected that the average debt-to-gross domestic product ratio of the 10 advanced country members of the Group of 20 developing and developed nations would mushroom to 118% by 2014. Such numbers have led some pundits to warn of a debt crisis, especially regarding the U.S.'s dependence on foreign creditors.

What's key now is that the recent market jitters could be self-fulfilling. Falling bond prices mean higher yields, which makes it harder for governments to refinance future obligations. That will hurt the currencies of those nations and will challenge fixed exchange rate regimes -- especially in the euro zone and for currencies pegged to the dollar.

Spain became the latest flashpoint Wednesday when Standard Poor's changed the outlook on its AA+ rating to negative. As it did when it downgraded Portugal's outlook Monday, S&P emphasized a weak growth outlook.

And with their bonds hammered for different reasons, Greece and Dubai's and Abu Dhabi's government-controlled entities have similarly seen ratings or outlook downgrades this week.

Also on Tuesday, Moody's acknowledged two elephants in the room. Although it referred to worst-case scenarios, the agency said the U.S. and the U.K.-- whose public debt runs to $12.1 trillion and $1.3 trillion, respectively--could potentially lose their triple-A ratings.

Meanwhile, analysts are worried about Japan, where deflation makes it ever-more expensive for the government to repay a debt that's projected to hit 220% of GDP in 2014.

Sovereign borrowers aren't supposed to default, at least not on local-currency debt, because their central banks can always print money. But Russia's ruble default in 1998 blew that theory away. And in any case, printing money to pay down the debt means robbing Peter to pay Paul: too often, we pay for it with inflation.

In theory, if a global capacity glut were to continue generating deflationary pressures, it might not be a problem to repay the debt with yet more "quantitative easing." But with so much liquidity already making inflation hawks nervous and fueling potential asset bubbles, pressures are rising for monetary tightening, not loosening.

And that's why sovereign strugglers are most at risk. When the European Central Bank hikes rates it's going to make Greece's interest obligations only more burdensome.

That raises questions about the entire euro zone. The ECB must pursue a policy that fits the price stability outlook for the 16-member euro zone as a whole.

But can debt-laden Greece handle that? Or Spain? Or Italy? What if a U.S. recovery pushes the Federal Reserve closer to an exit from its extraordinarily accommodative policy stance? That would hurt big sovereign debtors whose currencies are pegged to the dollar -- ike Dubai and Abu Dhabi.

Alternatively, what if the biggest shoe were to drop? Although it's near impossible to imagine the U.S. Treasury formally defaulting, many worry that its mammoth debt burden could lead to a dollar collapse. Then all bets are off.

None of these scenarios must play out. Nonetheless, they show why sovereign debt is the problem to watch.